Municipal bond investors relied heavily on credit ratings prior to the financial crisis, but rating downgrades post-crisis have caused investors to lose trust in the rating agencies.
By understanding the credit rating process, investors can reevaluate their trust in the municipal bond rating agencies.
Introduction to Credit Ratings
Credit ratings provide an easy-to-understand method of measuring the likelihood of default. Since the municipal market is highly fragmented, with hundreds of issuers, research coverage of individual municipalities is not as widely available as it is for stocks. As a result, retail investors rely on credit ratings if they are not familiar with the credit analysis process.
Prior to the financial crisis, over half of municipal bonds issued were insured. This meant a large portion of the municipal market was rated AAA, just as the bond insurers were. Downgrades to the insurers meant many municipal bonds were also downgraded, which shook investors’ confidence in the rating agencies. The loss of investor trust led to changes at the rating agencies.
The most prominent change came after the financial crisis in 2010, when Moody’s recalibrated their rating scale for municipal bonds to be in line with the ratings of other asset classes. Since the majority of municipal bonds issued currently are uninsured, understanding credit analysis has become even more important.
The Credit Rating Process
The rating process begins when an issuer contacts a rating agency to request a rating. The rating agency charges the issuer a fee for the rating. A lead analyst is assigned to review the financial statements of the issuer, interview management, and then recommend a rating to the committee that sets the rating. The analyst then issues the rating report.
The agencies base their credit ratings on a methodology that guides the rating process. The type of credit being rated determines the parameters that are important to analyze. Here are a few parameters analysts consider as part of this process:
- Tax Base – Taxes are the most common source of revenue for municipalities, and understanding the type of taxes that support debt payments is very important. GO bonds tend to be backed by ad valorem property taxes, while special revenue-backed debt may be backed by utility services or sales taxes. Evaluating trends in tax collection helps determine the long-term credit strength of the issuer. Rating agencies consider the full property value of the tax base and the full value on a per capita basis.
- Median Income Levels – Income levels tend to be correlated with education. High-income areas tend to have lower unemployment rates, which indicates a stronger economy. Low income levels may be an indicator that the economy is weakening and residents may be forced to leave the area to find work, suggesting a shrinking tax base.
- General Fund Balance – This is the main operating fund for bonds backed by general obligation credits. Rating agencies want to see that the municipality has the flexibility to handle a downturn in the economy. AAA-rated credits may have general fund balances greater than 30% of their annual revenue.
- Legal Structure – This is particularly important to special tax bonds backed by a specific revenue stream. Legal covenants may require the municipality to raise tax rates and serve as protection for investors. These covenants most commonly include an additional bonds test that limits the amount of debt that can be issued without raising rates and a debt service coverage requirement that sets the minimum allowable amount of revenue relative to maximum annual debt service payments.
- Operating History – Examining operating performance shows how well management has balanced revenue and expenditures. Ideally, revenues are consistently higher than expenditures and the municipality operates at a surplus. Rating agencies want to see how management responds when the municipality is stressed. If management has shown a willingness to cut expenditures or use their taxing authority to raise tax rates, this would warrant a stronger credit rating.
- Debt and Pensions –Total long-term obligations include both debt and pension payments. Total debt can be measured as a percentage of the full property value, as a ratio of total debt to annual operating revenue, or as a ratio of debt per capita. The net pension liability should also be evaluated based on its size relative to the tax base and total annual expenditures. In recent times, pension funding has trended lower as returns on pension assets have been constrained by low interest rates.
These parameters are some of the most important to consider when completing credit analysis. Comparing these parameters to peers and historical trends helps formulate an opinion on how the credit may change in the future.
The Bottom Line
By understanding the credit rating process and completing their own credit analysis, investors can improve their risk-adjusted returns through their own research, in addition to the credit opinions of the rating agencies.